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Diversity among banks may increase systemic risk

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  • Teruyoshi Kobayashi

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    (Graduate School of Economics, Kobe University)

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    Abstract

    The problem of how to stabilize the financial system has attracted considerable attention since the global financial crisis of 2007-2009. Recently, Beal et al. (2011, gIndividual versus systemic risk and the regulatorfs dilemmah, Proc Natl Acad Sci USA 108: 12647-12652) demonstrated that higher portfolio diversity among banks would reduce systemic risk by decreasing the likelihood of simultaneous defaults. Here, I show that this result is overturned once a financial network comes into play. In a networked financial system, the failure of one bank can bring about a contagion of failure. The optimality of individual risk diversification, as opposed to economy-wide risk diversification, is thus restored. I also present a new method to quantify how the diversity of bank size affects the stability of a financial system. It is shown that a higher diversity of bank size itself makes the financial system more fragile even if external risk exposure is controlled for. The main reason for this is that larger banks are more likely to become a gsuper spreaderh of infectious defaults. In this situation the social cost of letting a bank fail is not uniform and depends on the size of the failing bank. This strongly implies that larger banks are systemically more important than smaller banks, and preventing large banks from being exposed to high external risks would therefore be the most effective vaccine against financial crisis.

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    File URL: http://www.econ.kobe-u.ac.jp/RePEc/koe/wpaper/2012/1213.pdf
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    Bibliographic Info

    Paper provided by Graduate School of Economics, Kobe University in its series Discussion Papers with number 1213.

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    Length: 18pages
    Date of creation: Aug 2012
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    Handle: RePEc:koe:wpaper:1213

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    Web page: http://www.econ.kobe-u.ac.jp
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    Keywords: Systemic risk; financial crisis; financial network;

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    1. Larry Eisenberg & Thomas H. Noe, 2001. "Systemic Risk in Financial Systems," Management Science, INFORMS, vol. 47(2), pages 236-249, February.
    2. Upper, Christian, 2011. "Simulation methods to assess the danger of contagion in interbank markets," Journal of Financial Stability, Elsevier, vol. 7(3), pages 111-125, August.
    3. Simone LENZU & Gabriele TEDESCHI, 2012. "Systemic risk on different interbank network topologies," Working Papers 375, Universita' Politecnica delle Marche (I), Dipartimento di Scienze Economiche e Sociali.
    4. Xavier Gabaix, 1999. "Zipf'S Law For Cities: An Explanation," The Quarterly Journal of Economics, MIT Press, vol. 114(3), pages 739-767, August.
    5. Iori, G. & Masi, G. D. & Precup, O. V. & Gabbi, G. & Caldarelli, G., 2005. "A network analysis of the Italian oversight money market," Working Papers 05/05, Department of Economics, City University London.
    6. Gai, Prasanna & Haldane, Andrew & Kapadia, Sujit, 2011. "Complexity, concentration and contagion," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 453-470.
    7. Helmut Elsinger & Alfred Lehar & Martin Summer, 2006. "Risk Assessment for Banking Systems," Management Science, INFORMS, vol. 52(9), pages 1301-1314, September.
    8. Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2008. "Network models and financial stability," Bank of England working papers 346, Bank of England.
    9. F. Kyriakopoulos & S. Thurner & C. Puhr & S. W. Schmitz, 2009. "Network and eigenvalue analysis of financial transaction networks," The European Physical Journal B - Condensed Matter and Complex Systems, Springer, vol. 71(4), pages 523-531, October.
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